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Income from Sales or Settlements of Life Insurance Contracts

By Dawn M. Beatty, CPA, EEPB, P.C., Houston, TX

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Editor: Stephen E. Aponte,
CPA

Life insurance contracts have a plethora of
tax complexities with varying tax implications. In Rev.
Rul. 2009-13, the IRS has provided guidance on the amount
and character of income that taxpayers recognize in the
surrender or sale of life insurance contracts. In Rev.
Rul. 2009- 14, the IRS has provided guidance to purchasers
of life insurance contracts for profit. Life insurance
contracts have long been in existence, but the Code did
not define them for tax purposes until Sec. 7702 was added
in 1984 by the Deficit Reduction Act of 1984, P.L. 98-369,
effective for co ntracts issued after December 31, 1984,
in tax years ending after December 31, 1984.

Life
insurance contracts have a plethora of tax complexities
with varying tax implications. In Rev. Rul. 2009-13, the
IRS has provided guidance on the amount and character of
income that taxpayers recognize in the surrender or sale
of life insurance contracts. In Rev. Rul. 2009-14, the IRS
has provided guidance to purchasers of life insurance
contracts for profit. Life insurance contracts have long
been in existence, but the Code did not define them for
tax purposes until Sec. 7702 was added in 1984 by the
Deficit Reduction Act of 1984, P.L. 98-369, effective for
co ntracts issued after December 31, 1984, in tax years
ending after December 31, 1984.

Life Insurance
Contract Defined

The term “life insurance
contract” as defined in Sec. 7702 means any contract that
is a life insurance contract under the applicable law, but
only if the contract:

Meets the cash
value accumulation test of Sec. 7702(b); or

Meets the guideline premium requirements of Sec.
7702(c) and falls within the cash value corridor of Sec.
7702(d).

Cash value accumulation test: A
contract meets the cash value accumulation test if, by the
terms of the contract, the cash surrender value of the
contract may not at any time exceed the net single premium
that would have to be paid at that time to fund future
benefits under the contract.

Guideline premium requirements: A
contract meets the guideline premium requirements if the
sum of the premiums paid under the contract does not at
any time exceed the guideline premium limitation as of
that time.

Cash value corridor: A contract
falls within the cash value corridor if the death benefit
under the contract at any time is not less than the
applicable percentage of the cash surrender value.
Additional information regarding the cash valuation
accumulation test, guideline premium requirements, and the
cash value corridor can be found in Sec. 7702 and its
regulations.

Taxation If Contract Meets
Definition and Insured Dies

If the contract meets
the life insurance contract definition, Sec. 101(a)
provides that amounts received are generally excluded from
gross income if paid by reason of the death of the
insured. The exclusion under Sec. 101(a) applies
regardless of whether the payment is made to the estate of
the insured or to an individua l, corporation,
partnership, or other beneficiary and whether it is made
directly or in trust.

Taxation If Contract Does
Not Meet Definition

If a contract does not meet
the life insurance contract definition, in general the
income on the contract for any tax year of the
policyholder shall be treated as ordinary income received
or accrued by the policyholder during that year (Sec.
7702(g)(1)). The term “income on the contract” means, with
respect to any tax year of the policyholder, the excess
of:

The sum of the increase in the net
surrender value of the contract during the tax year and
the cost of life insurance protection provided under the
contract during the tax year, over

The
premiums paid under the contract during the tax year.

Life Insurance Contracts Sold and
Purchased in the Secondary Market

Life insurance
contracts purchased by the insured are not always held
until death. The IRS issued guidance in Rev. Rul. 2009- 13
on the amount and character of income to be recognized
involving the surrender or sale of a life insurance
contract that meets the definitional requirements of Sec.
7702. The guidance is provided through three different
factual situations.

Situation 1—Surrender for cash surrender
value: A, an individual, entered into a life
insurance contract with cash value. Under the contract, A
was the insured, and the named beneficiary was a member of
A’s family. A had the right to change the beneficiary,
take out a policy loan, or surrender the contract for its
cash surrender value. The contract in A’s hands was not
property described in Sec s. 1221(a)(1)–(8) (i.e., it was
a capital asset).

A surrenders the contract for
its $78,000 cash surrender value, which reflects the
subtraction of $10,000 of “cost of insurance” charges
collected by the issuer for periods ending on or before
the surrender date. Through that date, A had paid $64,000
in premiums under the life insurance contract. A never
received any distributions under the contract and never
borrowed against the contract’s cash surrender value.

In general, under Sec . 72(e)(2), a nonannuity amount
that is received on or after the annuity starting date is
included in gross income, but only to the extent it
exceeds investment in the contract. Sec. 72(e) does not
specify whether income recognized on the surrender of a
life insurance contract is treated as ordinary income or
as capital gain. The life insurance contract is capital
asset property. However, Rev. Rul. 64-51 explicitly states
that the proceeds received from the surrender of, or at
the maturity of, a life insurance contract are ordinary
income to the extent that they exceed the cost of the
policy. Accordingly, the $14,000 of income recognized by A
on the surrender of the life insurance contract is
ordinary income.

Situation 2—Sale of cash value life insurance
contract: The facts are the same as in
situation 1, except that A sells the life insurance
contract for $80,000 to B, a person unrelated to A who
would suffer no economic loss upon A’s death.

Unlike situation 1, which involves the surrender of the
life insurance contract to the issuer of the contract,
situation 2 involves an actual sale of the contract.
Nevertheless, some or all of the gain on the sale of the
contract may be ordinary if the substitute for ordinary
income doctrine applies.

The Supreme Court has
held, under the substitute for ordinary income doctrine,
that cla ims or rights to ordinary income are not capital
assets (United States v. Midland-Ross Corp., 381
U.S. 54 (1965)). Claims or rights to ordinary income
include lump-sum payments attributable to income from or
accretions to the value of capital assets that otherwise
would have been ordinary income when recognized in the
future by the taxpayer (Prebola, 482 F.3d 610 (2d
Cir. 2007)). Thus, ordinary income that has been earned
but not recognized by a taxpayer cannot be converted into
capital gain by a sale or exchange.

The inside
buildup under A’s life insurance contract immediately
prior to the sale to B was $14,000 ($78,000 cash surrender
value less $64,000 aggregate premiums paid). If B had
surrendered the life insurance contract or held it to
maturity, this inside buildup would have been taxed as
ordinary income per Rev. Rul. 64-51. Hence, $14,000 of the
$26,000 of income that A must recognize on the sale of the
contract is ordinary income under the substitute for
ordinary income doctrine. The remaining $12,000 of income
is longterm capital gain within the meaning of Sec .
1222(3).

Situation 3—Sale of term (no cash value) life
insurance contract: The facts are the
same as in situation 1, except that the contract was a
level premium 15-year term life insurance contract without
cash surrender value. A paid premiums totaling $45,000 and
then sold the life insurance contract for $20,000 to B, a
person unrelated to A who would suffer no economic loss
upon A’s death.

A’s adjusted basis in the life
insurance contract for purposes of determining gain or
loss on the sale equals the total premiums paid under the
contract less charges for the provision of insurance
before the sale. Absent other proof, the cost of the
insurance provided to A each month is presumed to equal
the monthly premium under the contract (in this case,
$500). The cost of the insurance protection provided to A
during the 89½ months that A held the contract was $500 ×
89½ months, or $44,750. Hence, A’s adjusted basis in the
contract on the date of the sale to B was $250 ($45,000
total premiums paid less $44,750 cost of insurance
protection).

The life insurance contract was a
capital asset under Sec. 1221(a), and B held it for more
than one year. The term life insurance contract had no
cash surrender value. Hence, there was no inside buildup
under the contract to which the substitute for ordinary
income doctrine could apply. Therefore, the $19,750 of inc
ome that A must recognize on the sale of the contract is
long-term capital gain within the meaning of Sec. 12
22(3).

Effective date: Rev. Ru l. 2009-13
is effective immediately, but the holdings with respect to
situations 2 and 3 will not be applied adversely to sales
occurring before August 26, 2009.

Purchases of
Life Insurance Contracts at Profit

Rev. Rul.
2009-14 provides guidance on the amount and character of
income to be recognized by purchasers of life insurance
contracts at profit from a U.S. citizen. Consistent with
Rev. Rul. 2009- 13, the guidance pertains to life
insurance contracts that meet the definitional
requirements of Sec. 7702. Three different factual
situations are presented.

Situation 1—Payment of death
benefit: A and B are U.S. citizens residing
in the United States. B purchases from A for $20,000 a
life insurance contract on A’s life. The contract was a
level premium 15- year term life insurance contract
without cash surrender value. As owner of the contract, B
has the right to change the beneficiary and, pursuant to
that right, names himself beneficiary under the contract
immediately after acquiring the contract.

B had no
insurable interest in A’s life (except for the purchase of
the contract), had no relationship to A, and would suffer
no economic loss upon A’s death. B purchased the contract
with a view to profit. The contract in B’s hands was not
capital asset property described in Secs. 1 221(a)(1)–(8).
The likelihood that B would allow the contract to lapse by
failing to pay any of the remaining premiums was remote.

On December 31, 2009, A died, and IC, the domestic
corporation insurer, paid $100,000 under the life
insurance contract to B by reason of A’s death. Through
that date, B had paid monthly premiums totaling $9,000 to
keep the contract in force.

While generally gross
income does not include amounts received under a life
insurance contract if such amounts are paid by reason of
the death of the insured, in the case of a transfer for
valuable consideration, Sec. 10 1(a)(2) provides that the
amount excluded from gross income shall not exceed an
amount equal to the sum of the actual value of the
consideration paid and the premiums and other amounts
subsequently paid by the transferee. This “transfer for
value” rule does not apply in the case of a tr ansfer
involving a carryover basis or in the case of a transfer
to the insured, a partner of the insured, a partnership in
which the insured is a partner, or a corporation in which
the insured is a shareholder or an officer.

B
received $100,000 from IC by reason of the death of A, the
insured under the contract. Because B purchased the
contract from A in exchange for a purchase price of
$20,000, B’s acquisition of the contract was a “transfer
for a valuable consideration” within the meaning of Sec.
10 1(a)(2). Neither the carryover basis exception of Sec.
10 1(a)(2)(A) nor the exception for transfers involving
parties related to the insured under Sec. 10 1(a) (2)(B)
applied. Accordingly, Sec. 10 1(a) (1) excludes from B’s
gross income the amount received by reason of A’s death,
but Sec. 10 1(a)(2) limits the exclusion to the sum of the
actual value of the consideration paid for the transfer
($20,000) and other amounts paid by B ($9,000), or
$29,000. B therefore must include in gross income $71,000,
which is the difference between the total death benefit
received ($100,000) and the amount excluded under Sec. 10
1 ($29,000).

The life insurance contract was
property held by B not described in Secs. 1221(a)(1)–(8),
so it is a capital asset. However, neither the surrender
of a life insurance or annuity contract nor the receipt of
a death benefit from the issuer under the terms of the
contract produces a capital gain. Therefore, the $71,000
income B recognized upon the receipt of death benefits
under the contract is ordinary income.

Situation 2—Investor sells policy:
The facts are the same as in situation 1, except that A
does not die and on December 31, 2009, B sells the
contract to C (a person unrelated to A or B) for $30,000.

Under Sec. 1001(b), B’s amount realized from the s
ale of the life insurance contract is the sum of money
received from the sale, or $30,000. Regs. Sec.
1.263(a)-4(c)(1)(iv) requires taxpayers to capitalize an
amount paid to another party to acquire an intangible
(including a life insurance contract) from that party in a
purchase or similar transaction. B paid $20,000 to A to
acquire the life insurance contract from A, which is
included in B’s cost basis. B also paid $9,000 in monthly
premiums to prevent the contract from lapsing. No
deduction is allowed for these monthly premiums under Sec.
264.

Regs. Sec. 1.263(a)-4(b)(1)(iv) authorizes
the Service and Treasury to publish guidance that
identifies a future benefit as an intangible for which
capitalization is required. The premiums paid by a
secondary market purchaser of a term life insurance
contract serve to create or enhance a future benefit for
which capitalization is appropriate. Accordingly, Rev.
Rul. 2009-14 requires a secondary market purchaser to
capitalize premiums paid to prevent a term life insurance
contract (without cash value) from lapsing. However, the
Service will not challenge the capitalization of such
premiums paid or incurred prior to the issuance of this
ruling.

Therefore, B’s adjusted basis for purposes
of measuring gain on the sale to C was $29,000. Because
the amount realized on B’s sale of the life insurance
contract to C was $30,000 and the adjusted basis was
$29,000, B must recognize $1,000 on the sale to C. The
life insurance contract was property held by t he taxpayer
not described in Secs. 1221(a) (1)–(8) so it is a capital
asset. In addition, the contract was a term contract
without any cash value, so there was no buildup inside the
contract. Hence, the substitute for ordinary income
doctrine under Midland- Ross does not apply, and
the $1,000 of gain recognized b y B on the sale of the
contract to C is long-term capital gain.

Observation: In the second
situation described in Rev. Rul. 2009-13, the taxpayer was
required to deduct “cost of insurance” charges from his
basis in the policy because he had received the benefit of
insurance coverage. However, in this case B, who is
totally unrelated to A, purchased the insurance contract
as an investment, paid the policy premiums purely to
prevent the loss of the investment, and received no
insurance coverage for his premium payments. Therefore, B
is not required to reduce his basis in the policy by any
cost of insurance charges.

Situation 3—Foreign investor: The
facts are the same as in situation 1, except that B is a
foreign corporation that is not engaged in a trade or
business within the United States (including the trade or
business of purchasing, or taking assignments of, life
insurance contracts). As in situation 1, B must recognize
$71,000 of ordinary income upon the receipt of death
benefits. This income is “fixed or determinable annual or
periodical” income within the meaning of Sec. 881(a)(1).
(See Regs. Sec. 1.1441-2(b); Rev. Rul. 64-51; and Rev.
Rul. 2004-75.) Consequently, B is subject to tax under
Sec. 881(a) with respect to this income if the inc ome is
from sources within the United States. In the current
situation, A is a U.S. citizen residing in the United
States, and the issuing insurance company is a domestic
corporation. B’s income is from sources within the United
States.

Conclusion

As demonstrated by
Rev. Ruls. 2009-13 and 2009-14, the purchase and
disposition of a life insurance contract may require the
taxpayer and his or her adviser to analyze a multitude of
Code sections to determine the amount of income to be
recognized and the character of that income—which may
render unanticipated results. Proper analysis and planning
are therefore critical to avoid unfavorable outcomes.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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